Why do auditors disclaim? | China Accounting Blog | Paul Gillis

Why do auditors disclaim?

Last week Tianhe Chemicals (Tianhe), a Chinese company listed in Hong Kong, announced that its auditor, Deloitte, was planning to disclaim an opinion on its financial statements. Tianhe was the target of an activist short seller campaign by Anonymous Analytics last September and a damaging analysis by the Associated Press in November. Also last week Sihuan Pharmaceuticals (Sihuan) published its annual report for 2014 including a disclaimer opinion on its financial statements by auditor PwC. PwC used seven pages to explain why it was unable to express an opinion on the financial statements. Both stocks remain suspended.

Disclaimer opinions are rare, so two in one week is notable. These opinions are rare because they are useless to companies and investors, so companies generally will not accept them. Regulators and exchanges are unlikely to accept a disclaimer opinion, which explains why these stocks are suspended and are likely to remain so.

There are four types of audit opinions. A clean opinion (also called an unqualified opinion) means that the auditor believes that the statements follow GAAP and are free from material error. Unqualified opinions are the most common audit opinions. The terminology can be confusing to the layman. I had several clients in my career demand a qualified opinion since they certainly did not want an unqualified one, and it took some effort to explain that unqualified is better than qualified.

Qualified opinions indicate that an issue prevents the auditor from issuing a clean opinion. A qualified opinion can result from a deviation from GAAP, or a limitation on the ability of the auditors to examine a particular issue. Qualified opinions are generally bad news, but not necessarily fatal to a company.

There are two types of negative audit reports.The first is an adverse opinion, meaning the financial statements are materially misstated. I have never seen an adverse opinion, since no one is likely to accept and pay for a report that indicts them.

The second type of negative audit report is a disclaimer. Here the auditor refuses to opine on the financial statements. There are three likely reasons for a disclaimer. 1) The auditor may have discovered that they lack independence from the client (perhaps the partner invested in the client or slept with the CFO) so they cannot issue a clean opinion, even though there may be no problems with the financial statements. In such a case the company needs a new independent auditor. 2) There may be doubt about the ability of a company to survive another year. In this case auditors must include an explanatory paragraph (going concern qualification), which may lead to a disclaimer or simply a modified clean opinion. Disclaimers are viewed as revealing greater distress.

The third reason, present in both the Tianhe and Sihuan cases, is that the auditor is unable to obtain sufficient evidence to express a clean opinion. Tianhe said that the short attacks had “heightened the risk sensitivity” of its auditor, Deloitte. From what has been disclosed, it appears Deloitte is concerned about (i) construction in progress (ii) sales to a key customer which is a large SOE, and (iii) the inability to obtain bank statements from a large state-owned bank.

So, why didn’t the auditor just quit? Auditors sign an engagement letter with a client that promises to conduct an audit and express an opinion, although there is no promise as to what kind of opinion might be issued. When an auditor resigns without a good reason (such as management being caught in a bald-faced lie) the company may sue them for breach of contract for not completing the audit. So, in a troubled situation the auditor usually sticks around, and demands increasing evidence. We saw this play out at NQ Mobile, where PwC insisted on access to records of third parties before they would issue an unqualified report. NQ Mobile finally fired PwC and hired a non-Big Four auditor.

Firing the auditor and finding a replacement is probably the only option for both Tianhe and Sihuan, since I think it is unlikely the stock trades again until they have a clean audit opinion. I think it is unlikely that another Big Four firm will accept the clients without access to the evidence denied to the existing firms. Perhaps the companies will find a small accounting firm willing to do this, but as we saw with NQ Mobile, that is unlikely to lead to the stock price recovering.

Copyright 2015 Paul L. Gillis all rights reserved